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Corporate Tax Reform

City leaders must play their cards right to benefit locally from the likely changes to our nation’s flawed tax code.

Karen G. Mills and Jan W. Rivkin

It’s hard to find a fan of the current U.S. corporate tax code in either political party. Established in 1986, when companies were far less global and mobile, the code suffers from three major flaws. First, the statutory tax rate on corporate profits in America—35% for federal taxes plus about 4% for the typical state—is the highest among major developed countries; the weighted average among the other 33 OECD countries is 28.3% and has declined steadily over the years. The high statutory rate discourages businesses from investing and operating in the U.S. Second, the code is so shot-through with loopholes that the effective tax rate is much lower than the statutory rate, somewhere in the mid-20% range.[1] This is a bonanza for tax accountants and attorneys, but not for the country. Third, unlike almost all other countries, the United States taxes the profits that U.S.-headquartered corporations make overseas when those profits are brought back to America. That probably made sense in 1986, when U.S. corporations typically brought their overseas profits home. But today, this so-called “worldwide taxation” system encourages U.S. corporations to keep an estimated $2-3 trillion overseas instead of transferring it back to America to invest.

Donald Trump has proposed dropping the federal corporate tax rate from 35% to 15%; eliminating most corporate loopholes; and allowing companies to repatriate offshore profits at a one-time rate of 10%. Speaker of the House Paul Ryan has backed a comparable plan that reduces the corporate tax rate to 20%; eliminates most loopholes; and taxes repatriated cash at 8.75%. With Republican majorities in both houses of Congress, we are likely to see a push along these lines in 2017. Legislative success is far from certain, of course; tax reform is notoriously hard to pull off because so many and varied vested interests are in play. But the odds of success are higher than they have been in years.

Fixing an outdated corporate tax code is ultimately good news for America’s workers and cities. Intuitively, one might think that the main beneficiaries of lower corporate tax rates would be the shareholders of major corporations. But in fact, those shareholders are well-off regardless of the U.S. corporate tax code, thanks to the global mobility of capital; if the U.S. corporate tax code remains flawed, U.S. corporations will undertake more activities overseas, and they and their shareholders will prosper from those activities. The main impact of U.S. corporate tax reform is to shift the activities and investments of American corporations to U.S. locations, which creates jobs and boosts wages here rather than elsewhere. A recent nonpartisan study simulating the economic impact of various reforms concludes that reforms cause incomes to rise roughly equally (in percentage terms) across the income distribution.[2]

City leaders have a stake in precisely how the corporate tax code is reformed. Some proposals, for instance, have granted companies low tax rates on repatriated profits only if those profits are invested in certain ways—for instance, only if a portion is put into a fund that sponsors U.S. infrastructure investments. Personally, we would favor a repatriation scheme that gives companies an incentive to invest in the skills of their workforces. Scarce, valuable skills are a worker’s best guarantee that he or she will share in the prosperity of an employer. Past experience shows just how important it is for low-tax repatriation of profits to depend on businesses taking other actions that benefit the broad base of Americans. In 2004, corporations were granted a short “tax holiday”: they were allowed to bring overseas profits back to the U.S. at a tax rate of roughly 5%. According to a 2011 Senate Democratic staff report, the 15 companies that benefitted the most from the 2004 tax holiday subsequently cut total employment, increased share buybacks, decreased R&D, and raised executive compensation.[3] City leaders should lobby for repatriation arrangements that encourage companies to invest the returning profits in ways that benefit communities widely.

From HBS Digital Initiative

If the corporate tax code is reformed to allow repatriation of cash at a lower tax rate, city leaders would be wise to figure out which local employers are holding large reserves abroad and might be bringing them home. Such employers are prime candidates to expand their domestic operations and to create new jobs. Overseas cash holdings are concentrated in the high-tech and pharmaceutical sectors, with Microsoft, GE, Apple, Pfizer, IBM, Merck, Alphabet (Google), Johnson & Johnson, and Cisco each having more than $50 billion abroad.[4] Cities with connections to companies like these should look for ways to convert national changes in the corporate tax code into local prosperity.

YALP participants, how do you foresee corporate tax changes playing out? What are the implications for your city?

2 thoughts on “Corporate Tax Reform”

-The first is that the companies certainly aren’t unaware of the loopholes. This is why the effective rate is lower than the statutory rate. Investment is going to be driven by what a company will actually pay, not a topline number. The benefit is to accountants and lawyers yes, but also those companies who qualify for loopholes, or can afford the accountants and lawyers.

-That being said, the previous point brings me to my next one, which is that the tax code thus likely favors large companies. They are more effective at lobbying for tax cuts for their specific kinds of activity, and they are better equipped to take advantage of loopholes.

-Another thing to consider though: the panoply of loopholes are frequently cited as “distortions” (a kind of market-based inefficiency), and that eliminating these loopholes is an unabashed good. Jan, you didn’t quite say either of those things above, although you *could* be read as having implicitly done something like the latter. But some deductions are probably driven a recognition of genuine market failures or other reasonable policy considerations. For instance, Jan’s proposal above regarding putting limits on how repatriated money (with lower taxes) is spent is one such example. It might be good policy, and it might be good economics if there is a market failure happening (say, the benefits of investing in the workforce accrue in a diffuse fashion, and so create a kind of collective-action problem). Getting rid of loooholes isn’t ALWAYS good.

-One other consideration for corporate tax policy. I agree that it’s effect on shareholders seems to be less straightforward than we’d tend to imagine. But in a post-Citizen’s United world, there may be other reasons to avoid allowing excessive concentrations of corporate wealth. This allows for too much political power, which can be used to hijack the regulatory state and tax code to stack the deck in favor of the already powerful. (Hence, the source of many of the loopholes!). I am probably not doing it justice, but Jan’s colleague Clay Christensen has suggested that this problem is one reason to favor a small state–the long arm of the state cannot be used for crony capitalism if the arm is in fact a short arm! I am not convinced, but it is provocative. In any case, per Jan’s point, it isn’t always clear what greater taxes will lead to–will higher taxes make big companies poorer and less able to lobby? Or will it just mean that they stash money offshore, or that they will respond to this higher tax rate as an incentive to dedicate more resources to lobbying for loopholes? Jan’s writing above suggests that they will do the money stashing. The latter (will they lobby more?) is also an empirical question–and I don’t know that anyone has researched it.

Back to work! Fun distracting myself today. I’ve basically written about all that I disagree with on the blog today (which means I don’t have too much to add!).

Thanks for the thought-provoking points, Ron. I completely agree that some “loopholes” are good for society. I’d distinguish between (a) the deductions and exemptions that compensate for some market failure (e.g., Ron’s workforce investment example) and (b) the deductions and exemptions that exist solely because someone lobbied effectively for his or her special interest. An example of (b) would be the tax credits companies get for producing ethanol from corn–essentially a subsidy to agricultural conglomerates, as far as I can tell.

Glad you mentioned Clay Christensen’s work. His wider work in this domain, on what he calls the Capitalist’s Dilemma, makes a provocative argument that companies systematically invest too little and unwisely in innovation. See it at https://hbr.org/2014/06/the-capitalists-dilemma.